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The Setting Sun – Japan’s Coming Debt Crisis

Japan’s Nikkei 225 stock average rose by around 23% in 2012 and has continued to rise in early 2013. Much of the increase was since the announcement of the election in late 2012, when the index rose by around 20%, outperforming 92 of 94 equity benchmarks around the world. Foreigners increased holding of Japanese equities by a net US$21 billion in the six weeks before Christmas.

The increase reflects faith in the reflation strategy of second time Prime Minster Shinzo Abe to increase growth through an additional US$120 billion of public spending and create inflation to reduce the debt to GDP ratio.

In the post war period, Japan enjoyed decades of strong economic growth – around 9.5% per annum between 1955 and 1970 and around 3.8% per annum between1971 and 1990. Since the collapse of the Japanese debt bubble in 1990, Japanese growth has been sluggish, averaging around 0.8% per annum. Nominal gross domestic product (“GDP”) has been largely stagnant since 1992. Japan’s economy operates far below capacity, with the difference between actual and potential GDP being 5- 7%.

The Japanese stock market is around 70-80% below its highs at the end of 1989. The Nikkei Index fell from its peak of 38,957.44 at the end of 1989 to a low of 7,607.88 in 2003. It now trades around 8,000-12,000. Japanese real estate prices are at the same levels as 1981. Short term interest rates are around zero, under the Bank of Japan’s (“BoJ”) Zero Interest Rate (“ZIRP”). 10 year Japanese government bonds yield around 1.00% per annum.

Since 1990, public finances have deteriorated significantly. Government spending to stimulate economic activity has outstripped tax revenues, resulting in a sharp increase in government debt. Japan’s total tax revenue is at a 24 year low. Corporate tax receipts have fallen to 50 year lows. Japan spends more than 200 Yen for every 100 Yen of tax revenue received.

Japanese government gross debt is now around 240% of GDP. Net debt (which excludes debt held by the government itself for monetary, pension and other reasons) is about 135%. Total gross debt (government, non financial corporation and consumer) is over 450% of GDP.

Japan’s large pool of savings, low interest rates and a large current account surplus has allowed the build-up of this large government debt.

Japan has a large pool of savings globally, estimated at around US$19 trillion. In recent years, household savings were complemented by strong corporate savings, around 8% of GDP. Around 90% of all Japanese Government Bonds (“JGBs”) are held domestically. Low interest rates make servicing the high levels of debt manageable.

If Japan continues to run large budget deficits, as is likely, then the falling saving rate and reversal in its current account will make it more difficult for the government to borrow, at least at current low rates.

Japanese household savings rates have declined from between 15% and 25% in the 1980s and 1990s to under 3%, reflecting decreasing income and the aging population. As more Japanese retire, inflows into JGBs will decrease making domestic funding of the deficit more difficult. Insurance companies and pension funds are increasingly selling their holdings or reducing purchases to fund the increase in payouts to people eligible for retirement benefits.

Since 2007, the Japanese trade account surplus has fallen sharply, turning into a deficit in 2012 due to an appreciating Yen, slower global growth and higher cost of energy imports. But Japan’s large portfolio of foreign assets (US$4 trillion, including US Treasury bonds of US$1 trillion) will cushion the effects for a time. But even if net income from foreign assets stays constant, Japan’s overall current account may move into deficit as soon as 2015.

As the drawdown on financial assets to finance retirement accelerates, Japan will initially run down its overseas investments, losing its net foreign asset position. Unless public finances improve, Japan ultimately will be forced to finance its budget deficit by borrowing overseas. Where the marginal buyers of JGBs are foreign investors rather than domestic Japanese investors, interest rates may increase, perhaps significantly.

Even at current low interest rates, Japan spends around 25-30% of its tax revenues on interest payments. At borrowing costs of 2.50% to 3.50% per annum, two to three times current rates, Japan’s interest payments will be an unsustainable proportion of tax receipts.

Higher borrowing costs will also trigger problems for Japanese banks, Japanese pension funds and insurance companies, which also have large holdings of JGBs.

To avoid the identified chain of events, Japan must address the core problems. Reductions in the budget deficit are difficult. Spending on social security accounts and interest expense now totals a major part of government spending. An aging population and shrinking workforce will continue to drive slower growth and lower tax revenues. Tax increases are politically unpopular. Reductions in the budget deficit are likely to reduce already weak economic activity, compounding the problems.

Japanese policy makers can maintain its zero rate policy and monetise debt to finance the government. Japan can try to inflate away their debt. But ultimately, Japan may have no option other than a de facto domestic default or restructuring to reduce its debt levels.

Investors and traders have repeatedly bet on a Japanese crisis, usually by short selling JGBs to benefit from higher rates. But the bet has failed each time, giving the strategy its name – the widow maker.

Economist Rudiger Dornbush once observed: “The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought”. Japan’s toxic combination of weak economic performance, large budget deficits, high and increasing levels of government debt, declining household savings and looming current account deficits is increasingly unsustainable.

© 2013 Satyajit Das

Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money